There was a good article recently in GoodReturns on Responsible Investing (RI).
If I was to be critical, I would disagree with the comment at the beginning of the article that starting with exclusions (or negative screening) is a good first step. (As the article explains exclusions or negative screening involves removing companies in a portfolio that are in bad/sin/egregious industries, for example, controversial weapons and tobacco.)
I would argue, that a good first step is to have a Responsible Investing Policy. And that this Policy includes incorporating Environmental, Social, and Governance (ESG) considerations into the investment process. The Policy may well lead to exclusions, or may even include excluding certain sectors such as tobacco.
A good RI policy would also include a level of engagement with underlying companies and the investment management industry on RI issues.
The consideration of ESG factors will broaden the understanding of a portfolio’s and security’s risks, which involves understanding predominately non-financial risks which may very well have a financial impact.
Nevertheless, having a ESG focus does not necessarily lead to exclusions, it may do, it may also temper the size of the allocation to a stock or sector. As a better understanding of the risks can be incorporated into the investment decision making process. Likewise, the RI approach could result in a combination of exclusions and sizing of portfolio allocations.
The ongoing RI research may lead to a blanket exclusion of sectors, which would be reflected in the RI Policy. I’d suggest this is the maturing of the RI approach over time, not the beginning, nor the beginning of the end!
I’d also suggest as the level of exclusions increases this is more ethical or social responsible investing, which is a subset of Responsible Investing i.e. exclusions is not what “Responsible Investing” is all about. RI is a very broad church.
Lastly, I would also argue that ESG is already mainstream in many parts of the world, the Responsible Investment Association of Australasia (RIAA) was set up in 2002 and many institutional investors have been embracing ESG for over a decade, as have broker reports included ESG/sustainability scores on companies.
Albeit there is confusion on just what is RI. The comments to GoodReturns article reflect this.
There is also a growing body of evidence, which has been around for some time, that incorporating ESG considerations into the investment process leads to better-informed investment decisions. As noted above, RI is a broad church and there are varying degrees of implementing RI.
Therefore, the criticism of RI around the fear of missing out and underperformance due to negative screens needs to be taken with a level of perspective. Not all RI approaches are a like, and therefore impacts on likely performance outcomes can vary.
One should not be quick to criticise RI giving the variation in approaches.
The evidence is not clear cut. The higher the level of negative screens and constraints on a portfolio the more likely it is to underperform.
Nevertheless, an appropriate RI approach can enhance returns, and certainly reduce portfolio risk.
Another criticism of RI is around fees. Fees just are not an issue in implementing a successful RI approach.
The NZ Super Fund is an example, they do have an appropriate fee budget to manage the Fund, which does not exclude them investing into higher fee investment strategies, e.g. hedge Fund strategies and Private Equity, yet they run a global best practice Responsible Investing approach. It would appear you can have both, appropriate fee level and an industry best practice RI approach. They certainly believe this will result in better investment outcomes over the longer term and will have more to pay out to the Government from the Fund in the future.
To date they have a good performance record and would not appear to have been negatively impacted from their RI approach, which includes negative screens.
The research on exclusions is mixed and varied. Comments to the GoodReturn’s article refer to Cliff Asness from AQR and his blog post on ESG. I have a lot of respect for Asness and read his blog.
My understanding on his position is that negative screening and divesting bad stocks is “actually at odds with the very point of ESG investing”.
Asness argues, if removing “bad/sin” stocks from a portfolio does help, it is an action that should be taken anyway for the sake of higher returns.
Nevertheless, IMO, an ESG framework helps identify those stocks that would fail or underperform due to ESG factors, thus the value of ESG focussed investment approach.
Please note AQR has an ESG policy.
Asness is not arguing against ESG investing, he is arguing against placing constraints on a portfolio, in this context of negative screens. Too many constraints and a portfolio will underperform in his opinion, not surprising given he is an active manager!
Interesting, Asness contends that the desired outcome from negative screening will lower the level of investment returns achieved by the sin stocks given their cost of capital will rise. Thus the “Virtuous” negative screening investor will achieve their desired outcome: less investment within the sin/bad sectors by those companies. Asness argues that the Virtuous investor will achieve this but incur lower levels of returns themselves. The price of being Virtuous.
Not to pick an argument with Asness, as I’d surely lose, those companies that focus on managing ESG risks may have a lower cost of capital relative to their industry peers, and therefore make higher returns on investments. Thus positive ESG screening results in higher returns, the additional benefits of incorporating ESG considerations into the investment process. I’d certainly see this playing out in the resource sector.
Interestingly the recently released RIAA annual benchmark report noted “a lack of awareness and advice among retail investors…., and… Financial advisers…. (but the) truth is in some pockets of the advisor community, they’ve been slow to understand what this is all about and often somewhat dismissive about clients’ interests in ethical and responsible investing. There are a lot of deeply entrenched myths that still pervade that space, ……………… there’s still a perception that there’s a performance cost, this latest research shows responsible investment funds have performed consistently over time. ”
RIAA saw “ESG integration as having a positive impact on performance and the historical question marks that hung over the relative performance of responsible investment funds were starting to lift.’
Therefore, you can still have an ESG approach without negative screening. Of course, you can also have varying levels of negative screening and maintain an ESG approach.
All up though, there is growing body of evidence that incorporating ESG considerations into the investment process leads to better-informed investment decisions. The performance impact from negative screening is more contentious and motives to implement negative screens more varied.
I argue strongly, incorporating ESG into the investment process and maintaining a robust and evolving RI policy will result in better investment outcomes over time.
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